June 26, 2007

The Wisdom of Asset Allocation

"God grant me the serenity to accept the things I cannot change, courage to change the things I can, and the wisdom to know the difference." Reinhold Niebuhr (1892-1971)

Those words underscore the foundation of prudent investing. There are things we can control and there are things we can not. Knowing the difference is imperative and "the wisdom" lies in the application of that knowledge...

Among the primary variables of investing, the investor may control: (1) the amount to be invested; (2) the allocation of the assets; (3) the holding period or time in the market; and (4) the timing of the investment. Where investors make their biggest mistake is focusing intently on trying to control the one investment variable that is uncontrollable -- (5) the outcome of the investment (amount of gain/loss)...

Although most investors understand that the vast majority do not beat the market averages, especially over long periods of time, it is in our fallible human nature to believe that we will be among the "above average." Whether one ascribes to Jack Bogle's rantings on Lake Wobegone, where everyone is above average, or to the validity of the Efficient Market Hypothesis (EMH) or not, it is difficult to argue against the evidence that the greatest advantages to be gained by the investor is within a combination of the four investment variables that are controllable.

The Amount to Be Invested:

Alone, this variable is the weakest so I won't place much energy here; however it should go without saying that investing more money (all other variables remaining constant) will yield the investor more at the end of the investment horizon than keeping the investment amount constant. It's simple math.

Asset Allocation:

Location, location, location. As with real estate, the location of an asset is a critical element to its success. The most commonly understood (and misunderstood) piece of asset allocation is with securities selection. Since I've put forth significant energy to this area in previous posts, feel free to brush up on your asset allocation skills with a review:

For purposes of this post, I'll expand on an often over-looked yet integral piece of the asset allocation puzzle -- tax efficiency:

Tax-inefficient assets, such as actively-managed and traded investments that are subject to short-term capital gains, are best held in tax-deferred accounts, such as IRAs and 401(k)s.

Other tax-inefficient assets are those that generate taxable income such as REITs and corporate bonds. These also are best held in tax-deferred accounts.

Conversely, tax-efficient ETFs and index funds are best held in tax-inefficient or "taxable" accounts such as a brokerage or joint accounts.

Some would argue that placing growth stocks in tax-advantaged accounts is prudent; however, if done correctly, placing those stocks or funds in taxable accounts can be beneficial (if the growth stocks appreciate, the investor harvests the returns at the lower capital gains rate and when there are losses, the losses can be "harvested" as tax deductions, where those losses are not deductible in a tax-advantaged accounts).

While each case is different, in general, a Roth IRA is favorable to the traditional IRA as the investment horizon increases.

Time In The Market:

I believe time in the market, with proper asset allocation, is preferable to "timing the market," which is a fool's game. In my view, time in the market refers to investing early, investing often, and staying in for the long-term. Albert Einstein called compounding interest "the most powerful force in the universe" and it represents "time in the market" at its best. Here's a classic example: Which would you rather have -- $1million today or one penny doubled every day for one month? If you chose the penny doubled then you are the "winner" with $5,368,709.12. Time exponentially expands the compounding effect. With less time to invest, even the most skilled traders will find themselves at an enormous disadvantage to compounding interest...

Timing the Market / Investment Outcome:

Since "timing the market" is intended to control the "investment outcome," I combine them into the same points: As for timing the market, of course it is a "controllable" investing variable and it is possible to accomplish successfully but how prudent can it be to attempt when the vast majority of investors are not successful at doing it?

Where investors are commonly misled here is with their own perception of investment gains and "chasing performance." For example, if you invest $100,000 into a stock and it returns 30% in the first year and loses 10% in the second, is your average return 20 percent? No. After the first year, you'll have $130,000 and after the second, you'll have $117,000 for a total gain of 17% (or roughly 8.5% compounded). If you just earned an "average" 10% per year, you'd have $121,000 at the end of year two. Now consider that you were the "average" investor and your "friend" earned 30% in the first year. Are you going to hold to your allocation earning "just" 10% or will you be tempted to jump to your friend's "strategy?" Being "average" has its merits...

In summary, investing should be a means of making money work for you not a means of making you work for it. As author, Mitch Anthony, puts it, "life is not about making money, money is about making a life."

TFPAuthor, Kent Thune, is the President and Owner of Atlantic Capital Investments, LLC (ACI), a fee-only, registered investment adviser based in Mount Pleasant, SC, near Charleston. ACI specializes in retirement, investments, and financial planning.

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